Published on: December 7, 2023
Amid the battle against inflation, concerns over a looming recession and geopolitical events, 2023 featured issues both concerning and complex. Yanick Desnoyers, Vice-President and Senior Economist at Addenda Capital, sheds light on economic conditions and addresses issues to watch out for in 2024.
We’ve gone from one end of the spectrum to the other: from an environment focused on avoiding low inflation, even deflation, to a scenario where the primary concern is runaway inflation. How does this regime shift impact financial markets?
YD: Prior to the Great Financial Crisis of 2008 (GCF), central banks had managed to keep inflation well under control. Low inflation in the wake of the GFC worried central banks for a while, but the onset of COVID led them to overstimulate economic activity, causing inflation to increase more than they wanted. Consequently, monetary policy pivoted toward combating rising inflation, altering the dynamic between equities and bonds. Debt securities no longer served as a counterbalance to riskier assets. For the first time in many years, these two key markets fell in tandem amid rising inflation.
Canada’s economic productivity lags behind that of the United States. Where does this gap come from, and what are the consequences?
YD: It’s accurate to say that our economy’s labour productivity trails that of our southern neighbours. Business investment-to-GDP ratios are much higher in the United States than in Canada, whether in intellectual property or even machinery and equipment. A prominent outcome of these differences is a more inflationary labour market on the Canadian side of the border. As a result, inflation, especially in the service sector, is likely to be more persistent next year than in the United States. (Service industries, which account for over 70% of Canada’s gross domestic product, include activities other than the extraction and production of goods.)
Some headlines suggest that rising interest rates expose Canadian mortgage borrowers to significant risk. Is this really the case?
YD: It’s true that mortgage rates have risen sharply and rapidly in Canada. That said, the situation of household balance sheets is by no means homogeneous. With 15 million households in Canada, approximately one third have a mortgage, another third rent, while the remaining third are debt-free homeowners. Therefore, rising interest rates do not impact household finances in the same way, affecting borrowers differently than lenders who benefit from increasing interest rates through higher investment income. Among mortgage holders, fewer than 500,000 households have taken out variable-rate mortgages with variable payments. In general, half of these will not come up for renewal before 2028. (A Bank of Canada analysis is available here.)
A year and a half after the Russian invasion of Ukraine, a new military conflict, between Israel and Hamas, is causing concern among some investors. What influence do geopolitics really exert on economic trends?
YD: Canada is fairly insulated from such conflicts since there are few direct economic effects through trade in goods and services. Canada’s economic exposure is heavily tied to the United States economy rather than that of the Middle East.
A more significant impact on the Canadian economy could occur in the event of a significant and sustained rise in oil prices if production in Iran were affected. This scenario could lead to a rise in the Canadian dollar and a strain on household spending due to increasing energy costs. As a general rule, geopolitical conflicts notwithstanding, these shocks tend to have temporary effects on financial markets, creating volatility and presenting short-term opportunities rather than medium-term risks.
Should we or shouldn’t we expect a recession in Canada?
YD: Given Canadian mortgage terms, which are predominantly 5 years or less, the impact of monetary policy tightening on households is twice as great as a similar tightening in the United States, where terms are generally 30 years. By contrast, the effects of monetary policy on household debt servicing in the United States are relatively limited. As a result, recession probabilities in the United States remain low, which also lowers the likelihood in Canada, given that a downturn South of the border typically causes a recession in Canada.
Furthermore, despite the Bank of Canada’s rate hikes, the economy is experiencing a significant increase in population, roughly around 3.0%. This demographic uptick acts as a counterweight, at least in part, to the effects of the rate hikes by supporting aggregate household spending. Consequently, the most likely scenario in Canada remains a slowdown in economic growth rather than a contraction.
Despite the increase in the Bank of Canada’s policy interest rate, inflation is still relatively higher than the official target. What remains to be done to bring inflation down to 2%?
YD: Some progress has been made as core inflation, according to Statistics Canada, now stands at 3.2%, compared with a peak of 5.5% in the summer of 2022. Nevertheless, inflation rates above 3% are deemed unacceptable, as they may influence wage settlements in the medium term at rates exceeding the 2.0% target.
However, inflation in services, which is more closely linked to cost dynamics in the labour market, remains higher at almost 4.0%. Canada’s weaker productivity performance could force our central bank to tighten monetary policy a little further to ensure that services price growth eventually trends downward to align more closely with the 2.0% target.
What will we need to watch out for in the early months of 2024?
YD: The recent pace of disinflation has been encouraging in Canada, as the annual change in core goods inflation stood at 2.4% in September. This is a marked improvement compared to the peak of 5.8% reached at the end of the second quarter last year. The central bank’s interest rate hikes had a lot to do with it. However, the downward trend in house prices has stopped, and prices have even recovered some in recent months, which could slow the decline of inflation’s housing component.
In addition, more favourable labour productivity growth data would be welcome in early 2024, as these have been deviating from their long-term trend for several quarters. This would provide some relief for the Bank of Canada, potentially alleviating the need to significantly curtail economic growth to achieve price stability.